INDEX

Introduction History of derivatives Need for financial derivatives Development of derivatives market in India Taxation Participants in the market Hedgers Speculators Arbitragers Options Options strategy Bullish strategy Bearish strategy Straddle Strangle Box spread Butterfly spread Valuation of options price Black scholes model Assumptions Binary model Benefits of trading in OPTIONS Glossary

INDEX
Introduction Derivatives permitted by SEBI History of derivatives Ancient and recent derivatives Need for financial derivatives Development of derivatives market in India Functions of derivatives in Indian market Derivatives permitted by SEBI Taxation Forward, futures, swap, option, warrants Difference in forwards and futures Participants in the market Hedgers Short hedge Hedging and shareholders Basis risk Long hedgers Arguments for and against hedging Hedge ratio Speculators Arbitragers Types of derivatives Over the counter Exchange traded Common derivative types Comparison of derivatives trading with other exchanges of countries Flow of cash and zero sum game Valuation Market and arbitrage free prices Determining market price Determining arbitrage free price Criticism Futures Currency futures Bond futures Stock index futures Specification of future contract Convergence of future price to spot price Operation of margins

Keynes and hicks Delivery Cash settlement Forwards Valuation Cost of carry Short selling Risk and return Options Options strategy Bullish strategy Bearish strategy Straddle Strangle Box spread Butterfly spread Swaps Fixed-for-floating rate swap, same currency Fixed-for-floating rate swap, different currencies Floating-for-floating rate swap, same currency Floating-for-floating rate swap, different currencies Fixed-for-fixed rate swap, different currencies Valuation and pricing Interest rate swaps Valuation of options price Black scholes model Assumptions Binary model Risk management tools Counter party risk Benefits of trading in derivatives Glossary

Introduction
In the last 20 years derivatives have become increasingly important in the world of finance. Futures and options are now traded actively on many exchanges throughout the world. Forward contracts, swaps, and many different types of options are regularly traded outside exchanges by financial institutions, fund managers, and corporate treasurers in what is termed the over-the-counter market. Derivatives are also sometimes added to a bond or stock issue. Derivatives are the most complex of financial instruments. The word derivative comes from the verb derive. A derivative is a contract whose value is derived from the value of another asset, known as underlying , which could be a share, a stock market index, an interest rate, a commodity, or a currency. For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean. Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price. The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset. For example, a farmer fears that the price of soybean (underlying), when his crop is ready for delivery will be lower than his cost of production. Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period). In this case, say the merchant agrees to buy the crop at Rs 9,000 per ton. Now, the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa. If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, the contract becomes even more valuable. This is because the farmer can sell the soybean he has produced at Rs .9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying. If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or for that matter even weather, then the derivative is known as a commodity derivative. If the underlying is a financial asset like debt instruments, currency, share price index, equity shares, etc, the derivative is known as a financial derivative. 4

History of derivatives
The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ. However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today's futures. The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardized around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today. Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well. Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges. National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading. The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005. Derivatives have the characteristic of leverage or gearing. With a small initial outlay of funds one can deal large volumes. Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.There is a huge variety of derivative products that are traded on organized exchanges or OTC markets.

The ancient derivatives

1400s 1600s Japanese rice futures dutch tulip bulb options

1800s

puts and call options

The recent: financial derivatives listed markets

1972 1973 1977 1981 1982 1983 1990 1991 1992 1993 Financial Currency Futures Stock Options Treasury Bond Futures Euro Dollars Futures Index Futures Stock Index Options Foreign Index Warrants And Leaps Swap Futures Insurance Futures Flex Options

OTC Markets
1981 1982 1983 Currency Swaps Interest Rate Swaps Currency And Bond Options

Need for financial derivatives

There are several risks inherent in financial transactions and asset liability positions. Derivatives are risk shifting devices, they shift risk from those who have it but may not want it to those who have the appetite and are willing to take it. The three broad types of price risks are as follows Market risk: market risk arises when security prices go up due to reasons affecting the sentiments of the whole market. Market risk is also referred to as systematic risk since it can not be diversified away because the stock market as a whole may go up or down from time to time. Interest rate risk: this risk arises in the case of fixed income securities such as treasury bills, government securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example the market price of fixed income securities could fall if the interest rate shot up. Exchange rate risk: in case of imports, exports, foreign loans or investments, foreign currency is involved which gives rise to exchange rate risk. To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have emerged.

Development of derivatives market in India

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws(Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with 7

single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent. Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.

Functions of derivatives in Indian market Derivatives enable price discovery, improve the liquidity of the underlying asset, serve as effective hedging instruments and offer better ways of raising money. They contribute substantially in to increasing the depth of markets. Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools. They provide better avenues for raising money. Derivatives improve the liquidity of the underlying instrument.

Derivatives permitted by SEBI

Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced in June 2003 and exchange traded interest rate futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004. During December 2007 SEBI permitted mini derivative (F&O) contract on Index (Sensex and Nifty). Further, in January 2008, longer tenure Index options contracts and Volatility Index and in April 2008, Bond Index was introduced. In addition to the above, during August 2008, SEBI permitted Exchange traded Currency Derivatives. A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria:-

The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis. The stocks median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stocks quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The market wide position limit in the stock shall not be less than Rs.50 crores.

A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued.

Taxation
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The income-tax Act does not have any specific provision regarding taxability from derivatives.The only provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. In the absence of a specific provision, it is apprehended that the derivatives contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to a maximum of eight years .As a result an investors losses or profits out of derivatives even though they are of hedging nature in real sense, are treated as speculative and can be set off only against speculative income.

Most derivatives can be summarized in the following categories: Forwards: A forward contract is a particularly simple derivative, a contract between two parties. It is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded in the over-the-counter marketusually between two financial institutions or between a financial institution and one of its clients. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Forward contracts on foreign exchange are very popular. Most large banks have a "forward desk" within their foreign exchange trading room that is devoted to the trading of forward contracts. Both sides are obligated to complete the deal, however there is a risk one side might default on its obligations. These are not traded on exchanges because they are negotiated directly between two parties. Features of Forward Contracts: Over the Counter Trading (OTC). No down Payment Settlement at Maturity. Linearity (Loss of a forward buyer is the gain of the forward seller) No Secondary Market Necessity of a third party Delivery. Forward Rate contracts for commodities. Forward Rate contracts for currency. Forward Rate contracts for Interest Rates.

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Futures: A contract essentially the same as a forward except the deal is struck via an organized and regulated exchange. There are three key differences between forwards and futures. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. As the two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored. The largest exchanges on which futures contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). On these and other exchanges throughout the world, a very wide range of commodities and financial assets form the underlying assets in the various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold, and tin. The financial assets include stock indices, currencies, and Treasury bonds. 1. Futures contract is guaranteed against default. 2. They are standardized. 3. They are settled on a daily basis. Short Position: This commits the seller to deliver an item at the contracted price on maturity. Long Position: This commits the buyer to purchase. Key features of Futures contracts: Standardization. Intermediation by the Exchange. Price Limits. Margin requirements. Marking to market. Standardization: It is standardized, so that it can be traded in the stock exchange. Intermediation by the exchange:

Marking to market: while the forward contracts are settled down the maturity date futures contracts are marked to market on a periodic basis. This means that profits and losses on future contracts are settled on a periodic basis. Types of Future Contracts (The Global scene types of Futures) 1. Commodity Futures 2. Financial Futures. Commodity Futures: A commodity futures is a future contract in commodities like agricultural products, metals and mineral etc. Some of the will established commodity exchanges are as follows. London Metal Exchange (LME) to deal in gold. Chicago Board of Trade (CBT) to deal in Soya bean oil.

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New York cotton Exchange to deal in cotton. Commodity exchange in New York (COMEX) to deal in agricultural products. International Petroleum Exchange of London (IPE) to deal in crude oil.

Swaps: A swap is an agreement made between two parties to exchange payments on regular future dates. Swaps are OTC products and there is a risk for default. Swaps are used to manage or hedge risk associated with volatile interest rates, currency exchange rates, commodity prices, and share prices. It can be considered a series of forward contracts. Options: Options are traded both on exchanges and in the over-the-counter market. There are two basic types of options. A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The price in the contract is known as the exercise price or strike price; the date in the contract is known as the expiration date or maturity. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself.4 Most of the options that are traded on exchanges are American. In the exchange-traded equity options market, one contract is usually an agreement to buy or sell 100 shares. European options are generally easier to analyze than American options, and some of the properties of an American option are frequently deduced from those of its European counterpart. It should be emphasized that an option gives the holder the right to do something. The holder does not have to exercise this right. This is what distinguishes options from forwards and futures, where the holder is obligated to buy or sell the underlying asset. Note that whereas it costs nothing to enter into a forward or futures contract, there is a cost to acquiring an option. An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him. The buyer pays a premium to the writer of the contract because the option provides flexibility as the buyer can choose whether or not to exercises it. Options are OTC and exchange products. It may be classified into two categories Options are of two types - Calls and Puts options: Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. Presently, at NSE futures and options are traded on the Nifty, CNX IT, BANK Nifty and 116 single stocks. Warrants: Options generally have lives of up to one year. The majority of options traded on exchanges have maximum maturity of nine months. Longer dated options are called Warrants and are generally traded over-the counter.

Difference among Forwards and Futures contract

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Sno. 1. 2. 3.

Forwards Essentially OTC contracts involving only the buyer and the seller. Both the parties have necessarily to perform the contract. There is no payment of initial margins.

4. 5. 6. 7. 8.

The maturity and size of the contract may be customized. Settlements take place only on the date of maturity. Credit or counter-party risk is higher. Markets for forward contracts are not very liquid. Physical delivery takes place on the maturity date.

Futures A contract traded through an exchange Buyer, Seller and exchanges are involved. The contract need not necessarily culminate in delivery of the underlying. To trade in futures contract, one has to become a member of the exchange by paying the initial margin and maintain a variable margin account too with the Futures Exchange. The maturity and size of contracts are standardized. Settlement is on a daily basis on all the outstanding contracts(marking to market on a daily basis). The futures exchange takes care of credit or counter-party risk. Futures contracts are highly liquid and can be closed out easily. Hardly 2% of the total contracts are delivered and taken delivery of.

Participants in the Derivatives Market:

Hedger: Reduces / eliminates his risk. Speculator: Bets on future movements in the price of an asset. Arbitrageur: Takes advantage of a discrepancy between prices in two different markets. Dealers work for major banks and securities houses. Hedgers consists of corporations, investment institutions, banks and governments that want to reduce exposure to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices. Speculators are those such as hedge funds that want to bet on the prices of commodities and financial assets and on key market variables such as interest, indices, and exchange rates. It is usually much cheaper to speculate using derivatives than on the underlying. As a result, the risks and returns are much greater. Arbitrageurs exploit mispricing in the market to create risk-free profits. Those that are not members of a future and options exchange have to employ a broker to fill their orders. Trading in these markets are regulated by Commodity Futures Trading Commission (CFTC) and International Swaps and Derivatives Association (ISDA) and the National Futures Association (NFA). Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

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Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. The explosive growth of derivatives in the developed centuries is fuelled by the following. The increased volatility in global financial markets. The technological changes enabling cheaper communication and computing power. Breakthrough in modern financial theory, providing economic agents a wider choice of risk management strategies and instruments that optimally combine the risk and returns over a large number of financial assets. Political developments wherein the role of government in economic arena has become more of a facilitator and less of a prime mover. Thus the move towards market oriented policies and the deregulation in financial markets has lead to increase in financial risk at the individual participants level. Increased integration of domestic financial markets with international markets.

Hedging
Many of the participants in futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. This risk might relate to the price of oil, a foreign exchange rate, the level of the stock market, or some other variable. A perfect hedge is one that completely eliminates the risk. In practice, perfect hedges are rare. To quote one trader: "The only perfect hedge is in a Japanese garden." For the most part, therefore, a study of hedging using futures contracts is a study of the ways in which hedges can be constructed so that they perform as close to perfect as possible. The hedger simply takes a futures position at the beginning of the life of the hedge and closes out the position at the end of the life of the hedge. In Chapter 14 we will examine dynamic hedging strategies in which the hedge is monitored closely and frequent adjustments are made. Throughout this chapter we will treat futures contracts as forward contracts, that is, we will ignore daily settlement. This means that we can ignore the time value of money in most situations because all cash flows occur at the time the hedge is closed out. Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could 15

have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counterparty is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Short hedge An investment strategy that is focused on mitigating a risk that has already been taken. The "short" portion of the term refers to the act of shorting a security, usually a derivatives contract, that hedges against potential losses in an investment that is held long (i.e., the risk that was already taken). If a short hedge is executed well, gains from the long position will be offset by losses in the derivatives position, and vise versa. An investment transaction that is intended to provide protection against a decline in the value of an asset. For example, an investor who holds shares of Nextel and expects the stock to decline may enter into a short hedge by purchasing a put option on Nextel stock. If Nextel does subsequently decline, the value of the put option should increase. Hedging and Shareholders One argument sometimes put forward is that the shareholders can, if they wish, do the hedging themselves. They do not need the company to do it for them. This argument is, however, open to question. It assumes that shareholders have as much information about the risks faced by a company as does the company's management. In most instances, this is not the case. The argument also ignores commissions and other transactions costs. These are less expensive per dollar of hedging for large transactions than for small transactions. Hedging is therefore likely to be less expensive when carried out by the company than by individual shareholders. Indeed, the size of futures contracts makes hedging by individual shareholders impossible in many situations. One thing that shareholders can do far more easily than a corporation is diversify risk. A shareholder with a well-diversified portfolio may be immune to many of the risks faced by a corporation. For example, in addition to holding shares in a company that uses copper, a well diversified shareholder may hold shares in a copper producer, so that there is very little overall exposure to the price of copper. If companies are acting in the best interests of well-diversified shareholders, it can be argued that hedging is unnecessary in many situations. However, the extent to which managements are in practice influenced by this type of argument is open to question. BASIS RISK The hedges in the examples considered so far have been almost too good to be true. The hedger was able to identify the precise date in the future when an asset would be bought or

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sold. The hedger was then able to use futures contracts to remove almost all the risk arising from the price of the asset on that date. In practice, hedging is often not quite as straightforward. Some of the reasons are as follows: 1. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. 2. The hedger may be uncertain as to the exact date when the asset will be bought or sold. 3. The hedge may require the futures contract to be closed out well before its expiration date. These problems give rise to what is termed basis risk. This concept will now be explained. The Basis The basis in a hedging situation is as follows: Basis Spot price of asset to be hedged - Futures price of contract used If the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures contract. Prior to expiration, the basis may be positive or negative. When the underlying asset is a low-interestrate currency or gold or silver, the futures price is greater than the spot price. This means that the basis is negative. For high-interest-rate currencies and many commodities, the reverse is true, and the basis is positive. When the spot price increases by more than the futures price, the basis increases. This is referred to as a strengthening of the basis. When the futures price increases by more than the spot price, the basis declines. This is referred to as a weakening of the basis Long hedgers A situation where an investor has to take a long position in futures contracts in order to hedge against future price volatility. A long hedge is beneficial for a company that knows it has to purchase an asset in the future and wants to lock in the purchase price. A long hedge can also be used to hedge against a short position that has already been taken by the investor. For example, assume it is January and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $1.50 per pound, but the May futures price is $1.40 per pound. In January the aluminum manufacturer would take a long position in 1 May futures contract on copper. This locks in the price the manufacturer will pay. If in May the spot price of copper is $1.45 per pound the manufacturer has benefited from taking the long position, because the hedger is actually paying $0.05/pound of copper compared to the current market price. However if the price of copper was anywhere below $1.40 per pound the manufacturer would be in a worse position than where they would have been if they did not enter into the futures contract.

ARGUMENTS FOR AND AGAINST HEDGING The arguments in favor of hedging are so obvious that they hardly need to be stated. Most companies are in the business of manufacturing or retailing or wholesaling or providing a service. They have no particular skills or expertise in predicting variables such as interest rates, exchange rates, and commodity prices. It makes sense for them to hedge the risks associated with these variables as they arise. The companies can then focus on their main activitiesin which presumably they do have particular skills and expertise. By hedging, they avoid unpleasant surprises such as sharp rises in the price of a commodity.

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HEDGE RATIO The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure. 1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself. 2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged. 1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk. 2. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk.

Derivatives traders at the Chicago Board of Trade.

Speculation and arbitrage

Commercial speculation, i.e. speculation by buyers and sellers of commodities, has been used since the 19th century to enable commodity traders and processors to protect themselves against short term price volatility. Buyers are protected against sudden price increases, sellers against sudden price falls. For commodity buyers and sellers, commercial speculation is a form of price insurance. Noncommercial speculation takes place not to protect against or hedge price risk, but to benefit by anticipating and betting long for prices to go up or short for prices to go down. Non-commercial speculators provide capital to enable the ongoing function of the market as commercial speculators liquidate their contract positions by paying for the contracted commodity or selling the contract to offset the risk of other contract positions held. Non-commercial speculation is an investment, but one that can overlap with the interests of agriculture when appropriately regulated. However, todays speculation has become excessive relative to the value of the commodity as determined by supply and demand and other fundamental factors. For example, according 18

to the FAO, as of April 2008 corn volatility was 30 percent and soybean volatility 40 percent beyond what could be accounted for by market fundamentals. Price volatility has become so extreme that by July some commercial or traditional speculators could no longer afford to use the market to hedge risks effectively. Prices are particularly vulnerable to being moved by big speculative bets when a commoditys supply and demand relationship is tight due to production failures, high demand and/or lack of supply management mechanisms. Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution.

Types of derivatives
OTC and exchange-traded
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform. 19

Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

Common derivative contract types

There are three major classes of derivatives: 1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves. 2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction. 3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.

Examples

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Some common examples of these derivatives are: CONTRACT TYPES UNDERLYING Exchangetraded futures DJIA Index future NASDAQ Index future Exchangetraded options OTC swap OTC forward OTC option

Equity Index

Option on DJIA Index future Equity Option on swap NASDAQ Index future

Back-to-back n/a

Option on Eurodollar Eurodollar Money market future future Euribor future Option on Euribor future Bonds Bond future

Interest Forward rate rate swap agreement

Interest rate cap and floor Swaption Basis swap Bond option Stock option Warrant Turbo warrant Credit default option

Total Option on Bond return future swap Single-share option Equity swap Credit default swap

Repurchase agreement Repurchase agreement

Single Stocks

Single-stock future

Credit

n/a

n/a

n/a

Other examples of underlying exchangeables are:

Property (mortgage) derivatives Economic derivatives that pay off according to economic reports as measured and reported by national statistical agencies Energy derivatives that pay off according to a wide variety of indexed energy prices. Usually classified as either physical or financial, where physical means the contract includes actual delivery of the underlying energy commodity (oil, gas, power, etc.) Commodities Freight derivatives Inflation derivatives Insurance derivatives Weather derivatives Credit derivatives

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Cash flow
The payments between the parties may be determined by:

the price of some other, independently traded asset in the future (e.g., a common stock); the level of an independently determined index (e.g., a stock market index or heatingdegree-days); the occurrence of some well-specified event (e.g., a company defaulting); an interest rate; an exchange rate; or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the underlying security or commodity directly.

Valuation

Total world derivatives from 1998-2007 compared to total world wealth in the year 2000

Market and arbitrage-free prices

Two common measures of value are:

Market price, i.e. the price at which traders are willing to buy or sell the contract. 22

Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts.

Determining the market price

For exchange-traded derivatives, market price is usually transparent (often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time). Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.

Determining the arbitrage-free price

The arbitrage-free price for a derivatives contract is complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model.

Criticisms
Derivatives are often subject to the following criticisms:

Possible large losses

The use of derivatives can result in large losses due to the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as: The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the US federal government. An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written. It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters. The loss of $7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures contracts. The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted. The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.

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The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded. Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years.

Futures
A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures. The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract. Currency Futures Currency futures were first introduced in the international money market in Chicago, USA in the year 1972. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short in the same type of contract to offset your position. This serves to exit your position, much like selling a stock in the equity markets would close a trade. Currency futures are futures markets where the underlying commodity is a currency exchange rate, such as the Euro to US Dollar exchange rate, or the British Pound to US Dollar exchange rate. Currency futures are essentially the same as all other futures markets (index and commodity futures markets), and are traded in exactly the same way. Futures based upon currencies are similar to the actual currency markets (often known as Forex), but there are some significant differences. For example, currency futures are traded via exchanges, such as the CME (Chicago Mercantile Exchange), but the currency markets are traded via currency brokers, and are therefore not as controlled as the currency futures.

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Some day traders prefer the currency markets, and some day traders prefer the currency futures. I recommend the currency futures as they do not suffer from some of the problems that currency markets suffer from, such as currency brokers trading against their clients, and non centralized pricing. Bond futures Stock index futures

Settlement and Delivery

As currency futures are based upon the exchange rates of two currencies, they are settled in cash, in the underlying currency. For example, the EUR futures market is based upon the Euro to US Dollar exchange rate, and has the Euro as its underlying currency. When a EUR futures contract expires, the holder receives delivery of $125,000 worth of Euros in cash. Note that this only happens when the contract expires, and as day traders do not usually hold futures contracts until they expire, they should not be involved in the settlement, and will not receive delivery of the underlying currency.

Popular Currency Futures

Many of the most popular futures markets that are based upon currencies are offered by the CME (Chicago Mercantile Exchange), including the following :

EUR - The Euro to US Dollar currency future GBP - The British Pound to US Dollar currency future CHF - The Swiss Franc to US Dollar currency future AUD - The Australian Dollar to US Dollar currency future CAD - The Canadian Dollar to US Dollar currency future RP - The Euro to British Pound currency future RF - The Euro to Swiss Franc currency future

Futures contracts are now traded very actively all over the world. The two largest futures exchanges in the United States are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). The two largest exchanges in Europe are the London International Financial Futures and Options Exchange and Eurex. Example:-We examine how a futures contract comes into existence by considering the corn futures contract traded on the Chicago Board of Trade (CBOT). On March 5, an investor in New York might call a broker with instructions to buy 5,000 bushels of corn for delivery in July of the same year. The broker would immediately pass these instructions on to a trader on the floor of the CBOT. The broker would request a long position in one contract because each corn contract on the CBOT is for the delivery of exactly 5,000 bushels. At about the same time, another investor in Kansas might instruct a broker to sell 5,000 bushels of corn for July delivery. This broker would then pass instructions to short one contract to a trader on the floor of the CBOT. The two floor traders would meet, agree on a price to be paid for the corn in July, and the deal would be done. 25

The investor in New York who agreed to buy has a long futures position in one contract; the investor in Kansas who agreed to sell has a short futures position in one contract. The price agreed to on the floor of the exchange is the current futures price for July corn. We will suppose the price is 170 cents per bushel. This price, like any other price, is determined by the laws of supply and demand. If at a particular time more traders wish to sell July corn than buy July corn, the price will go down. New buyers then enter the market so that a balance between buyers and sellers is maintained. If more traders wish to buy July corn than to sell July corn, the price goes up. New sellers then enter the market and a balance between buyers and sellers is maintained.

THE SPECIFICATION OF THE FUTURES CONTRACT When developing a new contract, the exchange must specify in some detail the exact nature of the agreement between the two parties. In particular, it must specify the asset, the contract size (exactly how much of the asset will be delivered under one contract), where delivery will be made, and when delivery will be made. Sometimes alternatives are specified for the grade of the asset that will be delivered or for the delivery locations. As a general rule, it is the party with the short position (the party that has agreed to sell the asset) that chooses what will happen when alternatives are specified by the exchange. When the party with the short position is ready to deliver, it files a notice of intention to deliver with the exchange. This notice indicates selections it has made with respect to the grade of asset that will be delivered and the delivery location.
The Contract Size

The contract size specifies the amount of the asset that has to be delivered under one contract. This is an important decision for the exchange. If the contract size is too large, many investors who wish to hedge relatively small exposures or who wish to take relatively small speculative positions will be unable to use the exchange. On the other hand, if the contract size is too small, trading may be expensive as there is a cost associated with each contract traded. Delivery Arrangements The place where delivery will be made must be specified by the exchange. This is particularly important for commodities that involve significant transportation costs. Delivery Months A futures contract is referred to by its delivery month. The exchange must specify the precise period during the month when delivery can be made. For many futures contracts, the delivery period is the whole month. The delivery months vary from contract to contract and are chosen by the exchange to meet the needs of market participants. For example, the main delivery months for currency futures on the Chicago Mercantile Exchange are March, June, September, and December; corn futures traded on the Chicago Board of Trade have delivery months of January, March, May, July, September, November, and December. At any given time, contracts trade for the closest delivery month and a number of subsequent delivery months. The exchange specifies when trading in a particular month's contract will begin. The

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exchange also specifies the last day on which trading can take place for a given contract. Trading generally ceases a few days before the last day on which delivery can be made. Daily Price Movement Limits For most contracts, daily price movement limits are specified by the exchange. If the price moves down by an amount equal to the daily price limit, the contract is said to be limit down. If it moves up by the limit, it is said to be limit up. A limit move is a move in either direction equal to the daily price limit. Normally, trading ceases for the day once the contract is limit up or limit down. However, in some instances the exchange has the authority to step in and change the limits. The purpose of daily price limits is to prevent large price movements from occurring because of speculative excesses. However, limits can become an artificial barrier to trading when the price of the underlying commodity is increasing or decreasing rapidly. Whether price limits are, on balance, good for futures markets is controversial. Position Limits Position limits are the maximum number of contracts that a speculator may hold. The purpose of the limits is to prevent speculators from exercising undue influence on the market. CONVERGENCE OF FUTURES PRICE TO SPOT PRICE As the delivery month of a futures contract is approached, the futures price converges to the spot price of the underlying asset. When the delivery period is reached, the futures price equalsor is very close tothe spot price. To see why this is so, we first suppose that the futures price is above the spot price during the delivery period. Traders then have a clear arbitrage opportunity: 1. Short a futures contract. 2. Buy the asset. 3. Make delivery. These steps are certain to lead to a profit equal to the amount by which the futures price exceeds the spot price. As traders exploit this arbitrage opportunity, the futures price will fall. Suppose next that the futures price is below the spot price during the delivery period. Companies interested in acquiring the asset will find it attractive to enter into a long futures contract and then wait for delivery to be made. As they do so, the futures price will tend to rise. The result is that the futures price is very close to the spot price during the delivery period. The figure illustrates the convergence of the futures price to the spot price. The first curve, futures price is above the spot price prior to the delivery month, and in the second curve the futures price is below the spot price prior to the delivery month.

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OPERATION OF MARGINS If two investors get in touch with each other directly and agree to trade an asset in the future for a certain price, there are obvious risks. One of the investors may regret the deal and try to back out. Alternatively, the investor simply may not have the financial resources to honor the agreement. One of the key roles of the exchange is to organize trading so that contract defaults are avoided. This is where margins come in. The investor is entitled to withdraw any balance in the margin account in excess of the initial margin. To ensure that the balance in the margin account never becomes negative a maintenance margin, which is somewhat lower than the initial margin, is set. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level the next day. The extra funds deposited are known as a variation margin. If the investor does not provide the variation margin, the broker closes out the position by selling the contract. KEYNES AND HICKS We refer to the market's average opinion about what the future price of an asset will be at a certain future time as the expected future price of the asset at that time. Suppose that it is now June and the September futures price of corn is Rs. 200 It is interesting to ask what the expected future price of corn is in September. Is it less that Rs. 200 , greater than Rs. 200, or exactly equal to Rs. 200 ? If the expected future spot price is less than Rs. 200, the market must be expecting the September futures price to decline so that traders with short positions gain and traders with long positions lose. If the expected future price is greater than Rs. 200 the reverse must be true. The market must be expecting the September futures price to increase so that traders with long positions gain while those with short positions lose. Economists John Maynard Keynes and John Hicks argued that if hedgers tend to hold short positions and speculators tend to hold long positions, the futures price of an asset will be below its expected future spot price. This is because speculators require compensation for the risks they are bearing. They will trade only if they can expect to make money on average. Hedgers will lose money on average, but they are likely to be prepared to accept this because the futures contract reduces their risks. If hedgers tend to hold long positions while speculators hold short positions, Keynes and Hicks argued that the futures price will be above the expected future spot price for a similar reason.

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When the futures price is below the expected future spot price, the situation is known as normal backwardation; when the futures price is above the expected future spot price, the situation is known as contango. DELIVERY Very few of the futures contracts that are entered into lead to delivery of the underlying asset. Most are closed out early. Nevertheless, it is the possibility of eventual delivery that determines the futures price. An understanding of delivery procedures is therefore important. The period during which delivery can be made is defined by the exchange and varies from contract to contract. The decision on when to deliver is made by the party with the short position, whom we shall refer to as investor A. When investor A decides to deliver, investor A's broker issues a notice of intention to deliver to the exchange clearinghouse. This notice states how many contracts will be delivered and, in the case of commodities, also specifies where delivery will be made and what grade will be delivered. The exchange then chooses a party with a long position to accept delivery. Cash Settlement Some financial futures, such as those on stock indices, are settled in cash because it is inconvenient or impossible to deliver the underlying asset. In the case of the futures contract on the S&P 500, for example, delivering the underlying asset would involve delivering a portfolio of 500 stocks. When a contract is settled in cash, it is simply marked to market on the last trading day, and all positions are declared closed. To ensure that the futures price converges to the spot price, the settlement price on the last trading day is set equal to the spot price of the underlying asset at either the opening or close of trading on that day. For example, in the S&P 500 futures contract trading on the Chicago Mercantile Exchange final settlement is based on the opening price of the index on the third Friday of the delivery month.

Forwards
VALUING FORWARD CONTRACTS The value of a forward contract at the time it is first entered into is zero. At a later stage it may prove to have a positive or negative value. Using the notation introduced earlier, we suppose Fo is the current forward price for contract that was negotiated some time ago, the delivery date is in T years, and r is the 7-year risk-free interest rate. We also define: K: Delivery price in the contract /: Value of a long forward contract today A general result, applicable to all forward contracts (both those on investment assets and those on consumption assets), is f = (F0- K)e~rT COST OF CARRY The relationship between futures prices and spot prices can be summarized in terms of the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset

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less the income earned on the asset. For a non-dividend-paying stock, the cost of carry is r, because there are no storage costs and no income is earned; for a stock index, it is r q, because income is earned at rate q on the asset. For a currency, it is r rf\ for a commodity with storage costs that are a proportion u of the price, it is r + u; and so on. Define the cost of carry as c. For an investment asset, the futures price is Fo = SoecT For a consumption asset, it is Fo = Soe{c-y)T where y is the convenience yield. SHORT SELLING Some of the arbitrage strategies presented in this chapter involve short selling. This trade, usually simply referred to as "shorting", involves selling an asset that is not owned. It is something that is possible for somebut not allinvestment assets. We will illustrate how it works by considering a short sale of shares of a stock. Suppose an investor instructs a broker to short 500 IBM shares. The broker will carry out the instructions by borrowing the shares from another client and selling them in the market in the usual way. The investor can maintain the short position for as long as desired, provided there are always shares for the broker to borrow. At some stage, however, the investor will close out the position by purchasing 500 IBM shares. These are then replaced in the account of the client from whom the shares were borrowed. The investor takes a profit if the stock price has declined and a loss if it has risen. If, at any time while the contract is open, the broker runs out of shares to borrow, the investor is short-squeezed and is forced to close out the position immediately even if not ready to do so. An investor with a short position must pay to the broker any income, such as dividends or interest, that would normally be received on the securities that have been shorted. The broker will transfer this to the account of the client from whom the securities have been borrowed. Risk and Return Another explanation of the relationship between futures prices and expected future spot prices can be obtained by considering the relationship between risk and expected return in the economy. In general, the higher the risk of an investment, the higher the expected return demanded by an investor. Readers familiar with the capital asset pricing model will know that there are two types of risk in the economy: systematic and nonsystematic. Nonsystematic risk should not be important to an investor. It can be almost completely eliminated by holding a well-diversified portfolio. An investor should not therefore require a higher expected return for bearing nonsystematic risk. Systematic risk, by contrast, cannot be diversified away. It arises from a correlation between returns from the investment and returns from the stock market as a whole. An investor generally requires a higher expected return than the risk-free interest rate for bearing positive amounts of systematic risk. Also, an investor is prepared to accept a lower expected return than the risk-free interest rate when the systematic risk in an investment is negative.

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Options

Options strategies
An option strategy is implemented by combining one or more option positions and possibly an underlying stock position. Options are financial instruments that give the buyer the right to buy (for a call option) or sell (for a put option) the underlying security at some specific point of time in the future (European Option) or until some specific point of time in the future (American Option) for a price (strike price), which is fixed in advance (when the option is bought). Calls increase in value as the underlying stock increases in value. Likewise puts increase in value as the underlying stock decreases in value. Buying both a call and a put means that if the underlying stock moves up the call increases in value and likewise if the underlying stock moves down the put increases in value. The combined position can increase in value if the stock moves significantly in either direction. (The position loses money if the stock stays at the same price or within a range of the price when the position was established.) This strategy is called a straddle. It is one of many options strategies that investors can employ. Options strategies can favor movements in the underlying stock that are bullish, bearish or neutral. In the case of neutral strategies, they can be further classified into those that are bullish on volatility and those that are bearish on volatility. The option positions used can be long and/or short positions in calls and/or puts at various strikes.

Bullish strategies
Bullish options strategies are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the time frame in which the rally will occur in order to select the optimum trading strategy. The most bullish of options trading strategies is the simple call buying strategy used by most novice options traders. Stocks seldom go up by leaps and bounds. Moderately bullish options traders usually set a target price for the bull run and utilize bull spreads to reduce cost. (It does not reduce risk because the options can still expire worthless.) While maximum profit is capped for these strategies, they usually cost less to employ for a given nominal amount of exposure. The bull call spread and the bull put spread are common examples of moderately bullish strategies. Mildly bullish trading strategies are options strategies that make money as long as the underlying stock price does not go down by the option's expiration date. These strategies may provide a small downside protection as well. Writing out-of-the-money covered calls is a good example of such a strategy.

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Bearish strategies
Bearish options strategies are the mirror image of bullish strategies. They are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the time frame in which the decline will happen in order to select the optimum trading strategy. The most bearish of options trading strategies is the simple put buying strategy utilised by most novice options traders. Stock prices only occasionally make steep downward moves. Moderately bearish options traders usually set a target price for the expected decline and utilise bear spreads to reduce cost. While maximum profit is capped for these strategies, they usually cost less to employ. The bear call spread and the bear put spread are common examples of moderately bearish strategies. Mildly bearish trading strategies are options strategies that make money as long as the underlying stock price does not go up by the options expiration date. These strategies may provide a small upside protection as well.

Straddle
An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly, but is unsure as to which direction. The stock price must move significantly if the investor is to make a profit. As shown in the diagram above, should only a small movement in price occur in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to perform. Additionally, on stocks that are expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.

Strangle
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An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be. The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

Box Spread
The box spread is a strategy that comes into play in the practice of options trading. The idea behind a box spread is to create a situation in which there is zero risk in regard to the payoff of the actions taken in the strategy. This essentially involves creating a chain of events that results in a no arbitrage assumption. The total of the net premium used in the acquisition process is to be equal to the present value of the payoff on the transaction.

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Box spreads make use of a series of puts and calls to obtain the desired result. Within the context of this strategy, the investor may choose to follow a bull spread with a bear spread in order to create the desired balance between premium and payoff. The bull spread may involve a long call option coupled with a short call option that is then followed by a bear spread that involves a long put option and a short put option. This series of transactions, when diagrammed, can easily be demonstrated in the form of a rectangular box, resulting in naming the procedure a box spread. Several factors can determine if a box spread is a feasible option for the investor. The condition of arbitrages plays a central role, since the balance of the results is directly impacted. Executing the puts and calls properly will also make a big difference to the success of the strategy. Choosing to short the wrong call, for example, will throw the entire equation out of line, and not result in the balance between the net premium and the present value that was hoped for. It is possible to create two different variations of the box spread. The long box spread will involve the utilization of four options, generally with the same underlying asset and the same terminal or payoff date. This is different from the short box spread, which will usually involve two options. In both instances, the same basic combination of puts and calls is used.

Butterfly spread
The butterfly spread is an options spread that is geared toward incurring only a limited amount of risk, while having the potential to provide a small amount of profit from the strategy. Essentially, the butterfly spread involves combining a bear spread with a bull spread, and requires following a strict process in order to maximize the chance for making a profit and still manage to limit risk. The actual process of executing a butterfly spread involves three different strike prices coupled with two lower transactions being part of the bull spread component and two higher transactions arranged in a bear spread. The trades can be arranged in various combinations of puts and calls, depending on the circumstances and the exact configuration that is anticipated to have the best chance of realizing a profit. Most analysts agree that there are four combinations of puts and calls that will result in a butterfly spread. One basic requirement of the butterfly spread is to arrange the buying and selling so that they involve a range of markets and several different expiration dates. Two of the options should have a higher strike price. Executing the bull and bear spreads to accomplish the butterfly spread is done with the hope that the underlying stock price will remain stable, as this will result in a modest profit from the premium income that is realized on the combination of the options. While it is important to note that the butterfly spread is designed to be a relatively safe investment tactic, there is some potential for loss. However, if the procedure is followed closely, and the right combination of securities is utilized in the butterfly spread, the chances for creating a small profit are very good. As an investment strategy for persons who tend to

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be somewhat conservative with investing, but do want to make some attempt to try something a little different, the butterfly spread is an excellent choice.

Swaps
A swap is an agreement between two companies to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of the cash flows involves the future values of one or more market variables. A forward contract can be viewed as a simple example of a swap. Suppose it is March 1, 2002, and a company enters into a forward contract to buy 100 ounces of gold for $300 per ounce in one year. The company can sell the gold in one year as soon as it is received. The forward contract is therefore equivalent to a swap where the company agrees that on March 1, 2003, it will pay $30,000 and receive 1005, where S is the market price of one ounce of gold on that date. Whereas a forward contract leads to the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges taking place on several future dates. The first swap contracts were negotiated in the early 1980s. Since then the market has seen phenomenal growth. In this chapter we examine how swaps are designed, how they are used, and how they can be valued. Our discussion centers on the two popular types of swaps: plain vanilla interest rate swaps and fixed for- fixed currency swaps.

Types
Being OTC instruments interest rate swaps can come in a huge number of varieties and can be structured to meet the specific needs of the counterparties. By far the most common are fixed-for-fixed, fixed-for-floating or floating-for-floating. The legs of the swap can be in the same currency or in different currencies. (A single-currency fixed-for-fixed rate swap is generally not possible; since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams; the only exceptions would be where the notional amount on one leg is uncertain or other esoteric uncertainty is introduced).

Fixed-for-floating rate swap, same currency

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a notional N for a term of T years. For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a notional USD 1 million for 3 years. The party that pays fixed and receives floating coupon rates is said to be long the interest swap. Interest rate swaps are simply the exchange of one set of cash flows for another. Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10

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million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this swap, the company would pay a floating USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in 20bps profit.

Fixed-for-floating rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X on a notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M (TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for 3 years. For nondeliverable swaps, the USD equivalent of JPY interest will be paid/received (according to the FX rate on the FX fixing date for the interest payment day). No initial exchange of the notional amount occurs unless the Fx fixing date and the swap start date fall in the future. Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one currency to a floating rate asset/liability in a different currency, or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate and the fx exposure.

Floating-for-floating rate swap, same currency

Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency A indexed to Y on a notional N for a tenure of T years. For example, you pay JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years. Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two indexes widening or narrowing. For example, if a company has a floating rate loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current rate difference) comes from the swap cost which includes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer.

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Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in currency B indexed to Y on a notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay floating USD 1M LIBOR on the USD notional 10 million quarterly to receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 4 years. To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market without a well known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate debt issuance program in Japan and they might lack sophisticated treasury operation in Japan. To overcome the above problems, it can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company:

FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the company converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss. USD and JPY interest rate risk. If the JPY rates come down, the return on the investment in Japan might go down and this introduces an interest rate risk component.

Fixed-for-fixed rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a term of T years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive USD 5.36% on the USD equivalent notional of 10 million at an initial exchange rate of USDJPY 120.

Valuation and pricing

The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily be computed using standard methods of determining the present value (PV) of the fixed leg and the floating leg. The value of the fixed leg is given by the present value of the fixed coupon payments known at the start of the swap, i.e.

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where C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is the number of days in period i, Ti is the basis according to the day count convention and dfi is the discount factor. Similarly, the value of the floating leg is given by the present value of the floating coupon payments determined at the agreed dates of each payment. However, at the start of the swap, only the actual payment rates of the fixed leg are known in the future, whereas the forward rates (derived from the yield curve) are used to approximate the floating rates. Each variable rate payment is calculated based on the forward rate for each respective payment date. Using these interest rates leads to a series of cash flows. Each cash flow is discounted by the zerocoupon rate for the date of the payment; this is also sourced from the yield curve data available from the market. Zero-coupon rates are used because these rates are for bonds which pay only one cash flow. The interest rate swap is therefore treated like a series of zerocoupon bonds. Thus, the value of the floating leg is given by the following:

where N is the number of floating payments, fj is the forward rate, P is the notional amount, tj is the number of days in period j, Tj is the basis according to the day count convention and dfj is the discount factor. The discount factor always starts with 1. The discount factor is found as follows: [Discount factor in the previous period]/[1 + (Forward rate of the floating underlying asset in the previous period Number of days in period/360)]. (Depending on the currency, the denominator is 365 instead of 360; e.g. for GBP.) The fixed rate offered in the swap is the rate which values the fixed rates payments at the same PV as the variable rate payments using today's forward rates, i.e.:

Therefore, at the time the contract is entered into, there is no advantage to either party, i.e.,

Thus, the swap requires no upfront payment from either party. During the life of the swap, the same valuation technique is used, but since, over time, the forward rates change, the PV of the variable-rate part of the swap will deviate from the unchangeable fixed-rate side of the swap. Therefore, the swap will be an asset to one party and a liability to the other. The way these changes in value are reported is the subject of IAS

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39 for jurisdictions following IFRS, and FAS 133 for U.S. GAAP. Swaps are marked to market by debt security traders to visualize their inventory at a certain time.

Risks
Interest rate swaps expose users to interest rate risk and credit risk.

Interest rate risk originates from changes in the floating rate. In a plain vanilla fixedfor-floating swap, the party who pays the floating rate benefits when rates fall. (Note that the party that pays floating has an interest rate exposure analogous to a long bond position.) Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party. This is not true with FTSE MTIRS Index

MECHANICS OF INTEREST RATE SWAPS The most common type of swap is a "plain vanilla" interest rate swap. In this, a company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. The floating rate in many interest rate swap agreements is the London Interbank Offer Rate (LIBOR). This was introduced in Chapter 5. LIBOR is the rate of interest offered by banks on deposits from other banks in Eurocurrency markets. One-month LIBOR is the rate offered on one month deposits, three-month LIBOR is the rate offered on three-month deposits, and so on. LIBOR rates are determined by trading between banks and change frequently so that the supply of funds in the interbank market equals the demand for funds in that market. Just as prime is often the reference rate of interest for floating-rate loans in the domestic financial market, LIBOR is a reference rate of interest for loans in international financial markets. To understand how it is used, consider a five-year loan with a rate of interest specified as six-month LIBOR plus 0.5% per annum. The life of the loan is divided into ten periods, each six months in length. For each period the rate of interest is set at 0.5% per annum above the six-month LIBOR rate at the beginning of the period. Interest is paid at the end of the period.

Valuation of options price Black scholes model

In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made a major breakthrough in the pricing of stock options. This involved the development of what has become known as the Black-Scholes model. The model has had a huge influence on the way 39

that traders price and hedge options. It has also been pivotal to the growth and success of financial engineering in the 1980s and 1990s. In 1997, the importance of the model was recognized when Robert Merton and Myron Scholes were awarded the Nobel prize for economics.

In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts.

Assumptions of the Black and Scholes Model:

1) The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.

2) European exercise terms are used

European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the 40

option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous It process. To understand what a continuous It process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An It process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.

6) Returns are log normally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.

Delta:
Delta is a measure of the sensitivity the calculated option value has to small changes in the share price.

Gamma:

Gamma is a measure of the calculated delta's sensitivity to small changes in share price.

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Theta:

Theta measures the calcualted option value's sensitivity to small changes in time till maturity.

Vega:

Vega measures the calculated option value's sensitivity to small changes in volatility.

Rho:

This following graphs show the relationship between a call's premium and the underlying stock's price. The first graph identifies the Intrinsic Value, Speculative Value, Maximum Value, and the Actual premium for a call.

Binary model
A useful and very popular technique for pricing a stock option involves constructing a binomial tree. This is a diagram that represents different possible paths that might be followed by the stock price over the life of the option. 42

Risk Management Tools

Derivatives are powerful risk management tools. To illustrate, lets take the example of an investor who holds the stocks of Infosys, which are currently trading at Rs 2,096. Infosys options are traded on the National Stock Exchange of India, which gives the owner the right to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30th June 2005. Now if the share price of Infosys remains less than or equal to Rs 2,200, the contract would be worthless for the owner and he would lose the money he paid to buy the option, known as premium. However, the premium is the maximum amount that the owner of the contract can lose. Hence he has limited his loss. On the other hand, if the share price of Infosys goes above Rs 2,220, the owner of the call option can exercise the contract, buy the share at Rs 2,220 and make profits by selling the share at the market price of Infosys. The upward gain can be unlimited. Say the share price of Infosys zooms to Rs .3,000 by June 2005, the owner of the call option can buy the shares at Rs 2,220, the exercise price of the option, and then sell it in the market for Rs 3,000. Making a profit of Rs 780 less the premium that has been paid. If the premium paid to buy the call option is say Rs 10, the profit would be Rs 770.

Counter-party risk
Derivatives (especially swaps) expose investors to counter-party risk. For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks only offer variable rates, swaps payments with another business who wants a variable rate, synthetically creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If interest rates have increased, it is possible that the first business may be adversely affected, because it may not be prepared to pay the higher variable rate. Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Unsuitably high risk for small/inexperienced investors

Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, 43

a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it. Add Moral Hazard spread over the risk.

Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by legendary investor Warren Buffett in Berkshire Hathaway's annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the 1920s-30s Great Depression.

Benefits
Nevertheless, the use of derivatives also has its benefits:

Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility. Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Definitions

Bilateral netting: A legally enforceable arrangement between a bank and a counterparty that creates a single legal obligation covering all included individual contracts. This means that a banks obligation, in the event of the default or insolvency of one

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of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.

Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps. Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof. Exchange-traded derivative contracts: Standardized derivative contracts (e.g. futures contracts and options) that are transacted on an organized futures exchange. Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the banks counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties. Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral. Lot size: Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.

High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk mortgage securities. Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional. Over-the-counter (OTC) derivative contracts : Privately negotiated derivative contracts that are transacted off organized futures exchanges.

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Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and/or have embedded forwards or options. Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with noncumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a banks allowance for loan and lease losses.

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